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Low-Income Housing Tax Credit (LIHTC): Overview & How It Works

Updated: November 23, 2022

A difficult but essential tool for the creation and maintenance of affordable rental housing is the Low-Income Housing Tax Credit (LIHTC).

Private investors are encouraged to participate in affordable housing projects under this programme by receiving a federal income tax credit. In service since 1986, there are around 3 million affordable housing units due to this tax credit.

Read on as we take a closer look at exactly what the low-income housing tax credit is, and show you how it works. 

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    KEY TAKEAWAYS

    • The low-income housing tax credit (LIHTC) is a tax incentive that subsidizes the creation of low-income housing. 
    • It works by offering a 10-year period tax credit to applicable projects. 
    • The LIHTC is managed by the federal government. Any funds are allocated to the states according to the population of each individual state. 
    • To qualify for the LIHTC, a project has to commit to renting to tenants earning less than the average median income. This is according to the area for a 15-year period.

    What Is the Low-Income Housing Tax Credit (LIHTC)?

    The low-income housing tax credit (LIHTC) is a tax incentive. Specifically, it’s for housing developers to purchase, construct, or renovate housing for low-income families and individuals. 

    The incentive was written into the Tax Reform Act of 1986.

    There are specific qualifications that any resident must fulfill in order to benefit from this type of housing project, including guidelines on maximum income.

    For those that invest in low-income housing projects, the Low-Income Housing Tax Credit offers an additional income incentive. Its goal is to encourage the construction of more affordable housing in areas that would otherwise be out of reach for low- and middle-income families. Multi-family homes are often the property kinds that qualify for the low-income housing tax credit.

    Credits mostly fall into two categories. The first type of credit comes in the form of a 9% credit that may only be used if the building project won’t be receiving any other credits or financial assistance from the government. The second category includes a 4% credit that may be combined with additional tax benefits. These credits are applied over ten years and can almost entirely offset the construction’s taxable expense.

    The federal government distributes the tax credits to each state. Following that, each state is free to decide which developers are eligible to use these credits for their housing developments. Since there are more applications than there are permits available for construction, not every developer or investor will be able to benefit from this program.

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    Qualifying for the Low-Income Housing Tax Credit

    There are a wide variety of properties that can be eligible for the Low-Income Housing Tax Credit. But on a state level, more projects are competing for credits than there are credits available. This is because they are allocated based on the population of the state. 

    In order to qualify for the LIHTC, any construction project must meet one of the following criteria: 

    • 20% or more of the rental units need to be rented to people making no more than 50% of the neighborhood average family income.
    • Renters in 40% or more of the rental units are making 60% or less of the area’s median income depending on the size of their families.
    • At least 40% of the rental apartments are still occupied by tenants, who typically earn little more than 60% of the area’s median income. Additionally, no renters renting apartments are making more than 80% of the median income.

    All of the projects that are receiving the LIHTC have to continue to meet at least one of these income conditions for a 15-year initial compliance period. If the project doesn’t meet the criteria, the value of the tax credit can be reclaimed. 

    A common criticism of the tax credit is that many of the properties in more desirable locations become no longer accessible for low-income households once the 15-year credit period has passed. 

    Support for People Looking for Low-Income Housing

    Low-income housing can refer to any residential project or housing building that rents out units to tenants who qualify under the low-income bracket. This is done by offering reduced rent based on the family size and income, or people that receive a federal stipend to help make their rental payments. 

    These residential units can either be managed in two ways. They can be privately managed by landlords or rental agencies that accept a government-issued payment. This would be in conjunction with the rental payments from their tenants. Or they could be managed by a housing authority. 

    The low-income housing tax credit is intended to promote the creation of further low-income housing. However, there are other types of support for people who are seeking low-income housing. There are a number of low-income housing subsidies that are offered through the Department of Housing and Urban Development (HUD).

    The qualifications for income can be found on the HUD’s website. They are subject to change as the average wage declines or grows in any given area. A prospective renter has to earn less than 50% of the average income in their area in order to qualify. 

    While the aid is available to families as well as single renters, there are qualifications for room counts in a prospective home. And single renters can be excluded from a housing project due to there not being enough properly sized units available. 

    Low-income housing shouldn’t be confused with affordable housing. This is for families who are spending more than 30% of their income on their rental expenses. 

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    Calculating Costs and Benefits of LIHTC

    It is estimated that the LIHTC costs around $9.5 billion per year in the United States. It is by far the largest federal program that encourages the creation of affordable rental housing for households with low incomes. 

    Supporters see it as a well-tuned program that increases the affordable housing stock considerably. The LIHTC addresses a major failure in the market, and that is the lack of quality, affordable housing for low-income communities. 

    Critics will argue that the federal subsidy per unit of new construction is actually higher than it needs to be. This is because of the wide range of intermediaries that are involved in its financing – each of which is compensated for their input. As a result of this, a lot of the tax subsidy doesn’t go directly into creating new rental housing stock. 

    Summary

    The low-income housing tax credit is a good example of a strong government scheme. Specifically, putting funding into creating quality housing for low-income communities. It benefits both parties. The construction industry receives a dollar-for-dollar reduction tax credit for their work. This helps them reduce their taxable income. And it benefits the communities by opening up new housing avenues and access to rental property. 

    However, as with any government program, it has its downsides. Making housing affordable units in a way that suits all parties is always going to be difficult. But the LIHTC is one step closer to helping low-income families have a roof over their heads. 

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    FAQS on Low-Income Housing Tax Credit (LIHTC)

    What Is the 50% Test?

    The 50% test applies to tax-exempt bonds that can receive the 4% LIHTC under IRC Section 42. This is on 100% of the qualified low-income units. But only if the project is financed at least 50% with tax-exempt bonds.

    What Is a Tax Credit Fund?

    Tax credit funds are funds where federal tax credits are allocated. This is on a state-by-state basis. In turn, the state will award these tax credits to individuals.

    What Is Section 42(a) of the IRS Code?

    Section 42(a) provides for a credit for investment. This is in certain low-income housing buildings.

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